Wednesday, September 19, 2012

Procter and Gamble (NYSE: PG) is a worldwide consumer products company, and one of the largest companies in the world. The company has grown its dividend for well over 50 years, and has a market cap of almost $190 billion.

Overall, I’m not particularly bullish on PG at this point. The returns have been positive since my PG dividend stock report from 2011 when I called the stock fairly valued and a “hold”, but the company seems to have a diminished moat and lackluster growth prospects. I think over the long-run, earnings will begin inching up and the rate of return will be positive, but I don’t view the current valuation as appropriate for the stock performance with a margin of safety. I would desire a 10% pullback or more to invest.

Overview

Founded in 1837, Procter and Gamble (symbol: PG) is now one of the largest companies in the world. They sell their products in over 180 countries and currently have a market capitalization of over $180 billion. The company is known as one of the most solid blue chip dividend stocks with the history of more than five decades of consecutive annual dividend growth and large product diversification.

The company operates in numerous segments, as outlined below.

Beauty
With brands like Head and Shoulders, Pantene, and Olay, Procter and Gamble brings in 24% of its sales and 22% of its earnings from its beauty segment.

Grooming
Another 10% of sales and 16% of earnings come from the grooming segment, which includes brands like Braun, Fusion, and Gillette.

Health Care
Procter and Gamble offers a number of feminine care, oral care, and symptom-care products, including Oral-B, Vicks, and Always. The company generates 15% of sales and 17% of earnings from this segment.

Fabric/Home Care
The company has a variety of brands like Duracell batteries, Tide detergent, and Febreeze air care, from which it generates 32% of revenue and 26% of earnings.

Baby/Family Care
Through brands like Bounty, Charmin, and Pampers, Procter and Gamble generates 19% of sales and 19% of earnings from baby and family care products.

In terms of geographic exposure, 39% of sales come from North America, 19% come from Western Europe, 18% come from Asia, 14% come from Africa, the Middle East, and Central/Eastern Europe, and 10% come from Latin America.

Ratios

Revenue

(Chart Source: DividendMonk.com)

Sales grew at an annualized rate of 5.7% over this period, but over a more recent period, sales growth has been flat. The company has restated numbers which are not shown here, and those point to mild growth. In some ways, the chart is not quite as bad as it looks, because the company was actively divesting brands over this period, including selling the large Folgers coffee brand to Smuckers, rather than focusing on growth. Still, investors are broadly and correctly unimpressed by Procter and Gamble’s performance over this period.

Earnings and Dividends

(Chart Source: DividendMonk.com)

In terms of earnings per share, the company grew at an annualized rate of 4.7%. However, earnings have declined over the later period as part of the cost-cutting.

The company has stated that it targets high single digit EPS growth. When combined with a dividend yield of over 3%, that would mean long-term low double-digit returns.

As far as the dividend is concerned, it currently yields 3.28% with a payout ratio of under 60%. The dividend has grown by a rate of 11% annually, and the most recent increase was 7%.

Approximate historical dividend yield at beginning of each year:

Year

Yield

Current

3.28%

2012

3.1%

2011

3.0%

2010

2.9%

2009

2.5%

2008

1.8%

2007

1.9%

2006

1.9%

2005

1.8%

2004

2.0%

Like many stocks, PG was overvalued several years ago, and had a lower yield. Plus, the payout ratio increased from around 40% to around 60% over this period.

In most years, PG spends more on stock buybacks than on dividends. Over the last 3 years, the company spent over $17 billion on share repurchases and over $17 billion on dividends. Based on 2012 results, the company’s shareholder yield is around 5.4%.

Balance Sheet

Total debt/equity for the company is under 50%, and the debt/income ratio is under 3x.

However, over 80% of the existing shareholder equity consists of goodwill. Much of PG’s growth was due to acquisitions.

The interest coverage ratio is very solid, at over 17. Taking everything into account, Procter and Gamble has a rather strong balance sheet, with manageable debt levels, a high interest coverage ratio, and good investment grades. The only real downside to the balance sheet is the large quantity of goodwill, but overall, it’s in good shape.

Investment Thesis

Procter and Gamble is the largest company in the world at what it does, and has 25 billion-dollar brands. The company’s goals, as stated in their most recent annual report, were for an organic sales growth rate of 1-2% above global market growth rates, earnings growth in the high single digits or low double digits, and for free cash flow to be 90% of earnings.

The company has pursued a global growth strategy, and has achieved 23% compound annual sales growth in Brazil, 25% compound annual sales growth in Russia, 27% compound annual sales growth in India, and 17% compound annual sales growth in China, over the last 10-year period.

Despite this, the performance hasn’t been particularly strong. The company was too big and too diverse, and has sold some of its brands in order to streamline the size of the business. As I’ve shown in the Dividend Toolkit and the monthly newsletter, it doesn’t take much core growth to get good returns, provided that the valuation is reasonable.

For example, if a company can achieve 2% annual volume growth and 3% pricing growth on that volume (basically in line with a standard inflation rate), then the revenue growth is around 5%. If a company then buys back 3% of its market cap instock buybacks each year and net profit margins remain static, then EPS growth is in the ballpark of 8%. Add a 3% dividend yield, and you’ve got a good investment on your hands.

But if margins deteriorate, or volume growth halts, then the picture can change. In addition, if the valuation of the stock is too high, it drives down the dividend yield and reduces the number of shares that the company can repurchase, which in turn reduces the EPS growth rate. That’s something that not everyone realizes: that for a company that does buybacks, a high stock valuation results in a measurable reduction in EPS growth compared to if the stock valuation were low. Slow and profitable growth works great when the valuation is low enough to provide double-digit returns.

For Procter and Gamble, they announced earlier in 2012 a plan to save $10 billion in operations by the end of 2016. Specifically, they call for $6 billion in savings on cost of goods (which comes out to around $1.2 billion per year), $3 billion in savings on overhead (reducing the number of employees, at about $600 million per year), and then $1 billion in savings from marketing, or around $200 million per year.

To do this and keep the top line intact means that these savings can go towards dividends, buybacks, or strengthening the balance sheet.

Risks

Procter and Gamble faces commodity cost risk and global currency risk. More specifically, they operate in a highly competitive industry, and if consumers are looking to reduce spending, they can switch and have switched to private label products. Plus, other branded companies with overlapping products, like Colgate, can fight for market share.

If the company doesn’t make good use of its advertising, maintain pricing power, and continue to grow global volume, then their earnings growth rate won’t match their target rate of high single digits or better per year.

Conclusion and Valuation

Overall, I find that the company’s performance has been unsatisfying, but a $10 billion cost savings plan is what is needed. The key is to find the company at a good price.

A 2 Stage Dividend Discount Model can be used to approximate a fair value for the stock. Assuming management’s projection of high single digit EPS growth is correct, we can use an 8% expected EPS and dividend growth rate for the stock over the next 10 years, followed by a more conservative growth rate of 6% thereafter. If a 10% discount rate is used, then we’re looking at a calculated fair value of a bit under $68, which is close to the current stock price of a bit over $68.

Overall, if the executive goals are taken as reasonable targets, then the stock valuation makes sense. But this remains unproven; EPS has not done very well over the last several years as the company has attempted to partially streamline itself. Expansion in the BRIC countries has been successful, and the streamlining of the company is welcomed, but a margin of safety is needed.

While a price in the upper-$60′s is not out of line, I wouldn’t look to buy unless a 10+% discount to that price were to occur.

Full Disclosure: As of this writing, I am long PG and SJM.
You can see my dividend portfolio here.

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